Pendleton Street Advisors


insight & investment commentary


Investment Commentaries: Second Quarter 2017

Index Returns 2nd Quarter Year to Date Trailing 12 Months
S&P 500 US Large Cap Index 3.07% 9.17% 17.78%
MSCI All Country World Stock Index 4.67% 11.91% 18.86%
Barclays Capital Aggregate Bond Index 1.58% 2.40% -0.41%
US Core Consumer Price Index - (Inflation) 0.01% 0.75% 1.74%

Most market segments ended the 2nd quarter of 2017 higher than they began it, both domestically and globally.  Foreign stocks in emerging and developed markets outperformed relative to the same time period last year, and have significantly outperformed US stocks in the first half of 2017. After a prolonged period of under-performance relative to US stocks, non-US stocks’ out-performance is worth pointing out. Bonds, both government and corporate, contributed to portfolio returns for the quarter and year-to-date; but are lagging on a year-over-year basis. Lagging bond performance is primarily due to the increase in short-term interest rates brought on by the Federal Reserve, as well as concerns that the expected increase in economic momentum has not yet materialized.

Looking Ahead: As we head into the second half of 2017, we remain wary of investors’ growing optimism despite slow economic growth and rising interest rates. That said, we also note positive developments such as the continuing recovery in US corporate earnings growth (see the chart below), and improving economic conditions globally. Additionally, equity valuation levels, while elevated, are not unrealistically high when compared to historical levels.

Given the current health of the credit, labor, and housing markets, as well as the improving business environment, we believe an economic recession and/or a substantial downturn in US equity markets (i.e. a decline of greater than 10%) is unlikely without a significant and unexpected catalyst.

Last quarter we discussed the importance of filtering current circumstances through a process grounded in long-term perspective. At that time in early April, market levels had stalled as investors came to grips with reality: the world had not changed as much or as quickly as they had expected. Then, without much in the way of change in underlying conditions, prices resumed their march higher. We cannot imagine a clearer indication of unyielding investor-optimism, prompting us to examine what that means for how we manage client portfolios.

There is nothing inherently right or wrong with optimistic attitudes or behavior.  At the end of the day, it is a decision to view the glass as half-full rather than half-empty. The presence of sustained investor-optimism is important because it demonstrates a shift in investor bias towards expectations of a better future instead of a worse one.

Our concern is this: In environments of strong optimism or pessimism, investors risk underestimating the importance of new information that opposes the dominant view.

In our experience, sentiment is both contagious and intoxicating. Not too long ago, any good news was quickly explained away as an anomaly in an otherwise abysmal environment. Now, nearly eight years into a bull market, negative prognosticators are all-but tarred and feathered by the mainstream press. These market mood swings have real impacts on the way professionals and individuals think about investing, as we discuss below.

Forecasting Under the Influence: To illustrate the extent to which popular opinion can influence perspectives, we have included a chart of the Citigroup Economic Surprise Index, which is an indicator of how consensus estimates of professional forecasters deviate from actual changes in economic indicators. We highlighted 2017 to point out the steep drop in the index this year, which indicates the extent to which professional forecasters misjudged the change (or lack thereof) in underlying economic conditions early in the year. While expectations of economic improvement may be warranted, forecasters allowed sentiment to influence their predictions of the speed and magnitude of change. Then, they over-reacted by assuming that since their predictions were wrong, the economy was in a tailspin.  Let’s hope they don’t drive the same way they forecast

Investing While Intoxicated: Individual investor-sentiment similarly over-shot reality in the early part of the year (see the chart of data from AAII’s US Investor Sentiment Index below), and then over-corrected to the downside while the increase in market levels resumed.

Both examples demonstrate the challenge faced by professionals and individual investors alike: to avoid placing too much importance on what the crowd is shouting, and instead focus on price levels and changes relative to the underlying fundamentals.  The mood of the crowd is an important factor to understand in managing portfolio risk in the short-term, but it will never be the basis upon which our investment decisions are made.

The recent performance of foreign developed-market stocks offers a practical example of how investing based on sentiment can play out. Euro-Area GDP is expected to grow in 2017 by the same amount it did in 2016: 1.7%. Yet, total return measured by the S&P Europe 350 Index has already exceed last year’s levels by 17.6% (see chart to the right). We believe the difference is two-fold:

1. Nothing comparable to Brexit has occurred to disrupt markets in Europe so far this year, and 

2. The underwhelming 1.7% GDP growth achieved in 2016 was better than most investors expected, given the seemingly unending political and social unrest throughout the continent.

In fully-diversified client portfolios, we maintained exposure to European equities throughout 2016 and into the present; not because we have a crystal ball, but because objective analysis led us to the conclusion that European companies in aggregate would continue to grow and pay dividends in the long-term, regardless of how much failure the market had priced in. This is an example of how our use of objective analysis along with the patience we are afforded by our clients allowed us to participate in this year’s gains, avoiding the mistake of exiting the position in late 2016 based on market-sentiment. Our decision to increase exposure to emerging market equities in January, which are up nearly 19% this year, is another example of the importance of seeking out facts rather than relying on popular opinion.

We often discuss the importance of asset allocation in portfolio management, but we also place significant importance on the allocation of our time and attention in managing your investments. As a result, we spend far more time making sure we understand how current conditions could impact your long-term investment objectives than we spend pondering whether we agree with market pundits.   We appreciate the trust you place in us, and we look forward to meeting with you soon.


Matt A. Morley, CVA, CEPA
Chief Investment Officer